Half Year 2020 Rural Funds Group Earnings Call
Mar 21, 2020 (Thomson StreetEvents) -- Edited Transcript of Rural Funds Group earnings conference call or presentation Monday, March 2, 2020 at 12:01:00am GMT
TEXT version of Transcript
* David Anthony Bryant
Rural Funds Group - MD & Director of Rural Funds Management Limited
* James Powell
Rural Funds Group - General Manager of IR & Marketing - Rural Funds Management Limited
James Powell, Rural Funds Group - General Manager of IR & Marketing - Rural Funds Management Limited 
Good morning, and welcome to the Financial Results Presentation for the Half Year Ended 31 December 2019 for the Rural Funds Group. My name is James Powell, I'm the General Manager of Investor Relations. And I'm joined today by Managing Director, David Bryant; Chief Financial Officer, Daniel Yap; and Chief Operating Officer, Tim Sheridan. We will commence this morning's webinar shortly. (Operator Instructions)
I'll now hand over to David Bryant.
David Anthony Bryant, Rural Funds Group - MD & Director of Rural Funds Management Limited 
Good morning, ladies and gentlemen. Welcome to the Presentation of the Financial Results of the Rural Funds Group for the 6-month Period Ending 31 December 2019. This is David Bryant speaking. This morning, I'll present to you the first 4 sections of the presentation. At the end of this, we will take questions when I'll be assisted by Tim Sheridan, Daniel Yap and James Powell.
Page 5 lists the key activities conducted by RFM on behalf of the Rural Funds Group from July 2019 to the present. This includes the arranged acquisition of 8 properties, primarily in the cattle sector, and the sale of RFM's 17 poultry farms. During the period, RFM improved the lessees for 2 assets, firstly, by merging 4 smaller almond lessees of the Mooral almond orchard; secondly, by re-leasing an existing cattle property, Rewan, to the ASX-listed AACo. The leased AACo provided a material uplift in rental income, reflecting higher productivity following development by RFM. These transactions and their impact on the financials will be presented in greater detail on subsequent slides.
Also on this page are 2 important actions taken by RFM in response to a misleading and false attack by a short seller Bonitas. Following this attack, RFM released a statement to the ASX which rejected entirely their intentionally misleading and false allegations. RFM also announced that it was obtaining legal advice for possible action against Bonitas and that RFM had immediately arranged an independent investigation by Ernst & Young. RFM released the EY independent investigation report via the ASX on 27 August 2019. The report found that the assertions contained within the Bonitas document were false. Furthermore, the report validated RFM's prior rejection of each of these claims.
RFM also took legal action against Bonitas in the Supreme Court of New South Wales. RFM alleged that Bonitas had contravened sections of the Corporations Act and the Australian Securities and Investments Commission Act. On 12 February, a judgment was handed down in favor of RFM. An excerpt from the judgment found that statements made by Bonitas were false in material particulars and materially misleading.
Despite these 2 highly credible and independent responses to the Bonitas allegations, RFM continues to trade at a discount to where it was prior to the release of their false allegations. RFM today makes an additional response to the false allegations of short sellers through today's release of our half year financial statements.
Some of the highlights of these financial statements are detailed at the bottom of this page. They include: an increase in adjusted funds from operations or free cash flow of 11% per unit; surplus cash coverage of distributions, demonstrated by a 76% payout ratio; a diversified portfolio of leases which generate cash for RFF with a long-weighted average expiry of 11.5 years; a healthy balance sheet with gearing below the target range of 30% to 35%; finally, an increased to RFF's FY '20 forecast AFFO to $0.135 per unit and the announcement of the FY '21 distribution of $0.1128 per unit in line with RFF's forecast 4% growth target.
I will now take you through these elements in detail. The next page provides the graph of the movements in the fund's assets derived from acquisitions, disposals, capital expenditure and valuations, starting on the left-hand side with the cattle sector denoted by a blue bar. During the period, RFF settled Beef City, a feedlot operated by JBS, and received an independent valuation for an aggregation of cattle properties located in Northern Queensland, called Natal. Natal was purchased by RFF in October 2017. The aim for this asset was to increase its productive -- productivity primarily through the development of additional water points. Since its acquisition, RFF has funded the development of an additional 16 water points, which is reflected in the valuation increase of $9.3 million or 18%, net of CapEx. Valuations during the period were also recorded for unleased water entitlements and macadamia orchards, the latter providing a 6% increase.
In December, RFM sold 17 poultry farms. After the 31st of December, RFM settled 3 cattle properties in -- located in Western Australia, which are leased to existing lessee Stone Axe Pastoral Company and a small cattle property located in Central Queensland. Two additional properties are forecast to settle this month. The balance of the movements pertained to capital expenditure and accounting adjustments, providing pro forma adjusted property assets of $928.9 million.
Page 7 of the presentation provides summaries of RFF's income, earnings and balance sheet for the half year ended December 2019 compared to the relevant prior period. Property revenue increased $6.9 million or 22% driven by additional income from the JBS feedlots, leases and accompanying J&F guarantee. Total comprehensive income increased 21%. Earnings per unit increased 16%. These metrics are a result of the combination of property revenue and revaluations already described. The key metric of AFFO, being the measure of actual cash after expenses, increased by $3.4 million or 10% on a per unit basis. From this, cash distributions of $0.0542 per unit were funded. This is in line with forecast and with surplus cash reflected in the payout ratio of 76%.
The next table of this page presents a summarized balance sheet. Adjusted total assets increased modestly by $4 million noting that the $72 million realized from the poultry asset sale just prior to the year-end is yet to be fully redeployed. As a consequence, gearing at the end of the period of 26.4% is below the target range of 30% to 35%. The adjusted net asset value per unit, inclusive of the value of water entitlements, is $1.84 as at 31 December.
The final page of this section presents detail on the debt facility and interest rate hedging position of RFF. At year-end, adjusting for pro forma acquisitions, the debt facility had headroom of $112 million. This is inclusive of $50 million, which has been preapproved for acquisitions by RFF's financiers. The loan-to-value ratio, or LVR, at 30 June is 43%. The difference between the LVR and gearing, which was reported on the previous slide, is due to the $75 million guarantee associated with the JBS transaction, which is added when calculating the LVR. The LVR is well within the 50% limit. The cost of debt funding and interest rate hedging has materially improved from 4.2% to 3.7%. 70% of RFF's debt is hedged for an average period of 8 years. Page 25 to 30 in the appendices contains additional information on the financial results and independent valuations.
The next section of the presentation provides a portfolio and strategy update. The image in this slide is from a cattle property in Central Queensland called Comanche. Pictured in the foreground is an annual forage crop, sorghum, sown between rows of leucaena, a perennial legume. These crops enable increased cattle-carrying capacity and increased daily weight gain. Casting you right at the background landscape, you'll notice the prevailing dry conditions when the image was taken in January. This picture, therefore, shows one example of how seasonal variations are expected, managed and mitigated by lessees, in this instance, using irrigation for growing forage crops. It should be noted seasonal variations are not a direct risk to RFF as lessees -- as leases are not linked to climatic conditions, commodity prices or operator profitability. Regardless, RFF can confirm that no properties are now impacted by the drought or bushfires. All RFF properties have received rainfall, initiating pasture growth and filling water storages as shown in the 2 recent pictures included on this page.
The next page describes RFF's strategy to continue to achieve 4% per annum distribution growth by leasing and, where appropriate, improving farms. RFM's agricultural operating knowledge is key to achieving this strategy by being able to better identify, assess and execute investment opportunities compared to a purely [passive] landlord. RFM is pursuing 3 broad types of investment opportunity. The graphic on the bottom right of this slide provides examples of these investment opportunities. These have been incorporated into a modified version of a graphic, which RFM has used since listing, showing various agricultural assets ordered from infrastructure predominant to natural resource predominant.
It's worth spending a few minutes to understand the investment opportunities RFM is pursuing. The first type of investment is located on the right-hand side of this chart: natural resource-predominant assets such as cropping and cattle properties. These assets are comprised predominantly of productive soils and may have water entitlements. Both of these types of asset increase in value over time. The other attribute of these assets is that they may have the opportunity to improve productivity through development. Examples were provided in the pictures in the 2 previous slides: water points to enable better pasture utilization, improved pasture or irrigated crops to improve weight gain and reduce seasonality. As these properties become more productive, their value and, therefore, income-earning potential, increases.
Moving left along the continuum of our assets, which are a mix of natural resource component and infrastructure. Infrastructure includes, for example, irrigation equipment and biological assets, such as wine grapes or nut trees. These commodities are typically more profitable than the former cropping or cattle enterprises and, therefore, the investment opportunities to develop pure and natural resource assets to these higher and better use. These more profitable commodities support higher rents, and the conversion to higher and better use may provide development gains.
Finally, on the left-hand side of this graphic are our infrastructure-predominant investments. Because these assets typically have negative growth due to the depreciating infrastructure, they compensate with higher income. An example of these types of assets are the recently disposed poultry farms. One of the catalysts for the sale of the poultry farms was an approaching requirement to rebuild poultry sheds. RFM determined that the income which would be generated by these assets under new contracts would not sufficiently compensate RFF for the cost of the redevelopment. As a result, RFM sold the assets. Another example of an infrastructure investment is the JBS feedlots and guarantee to J&F, which I'll discuss in greater detail on this next page.
The feedlots and guarantee are attractive infrastructure-type investments, coupled with a high-quality counterpart, the largest meat processing company in Australia owned by the largest animal protein processing company in the world. Due to increased demand for Australian beef, JBS has requested an increase to the guarantee from RFF. This will support increased working capital required for increased production. RFM has announced today it will seek unitholder approval to increase the guarantee by $25 million. The guarantee was previously approved overwhelmingly by unitholders. However, an additional approval is required for the increase.
Part of the rationale for RFM to seek the -- to increase the guarantee is that it generates higher returns for RFF. The return for FY '19 was 10.2% on an annualized basis, inclusive of interest cost savings. A similar return will be generated by the proposed increase. One of the false acquisitions made by short sellers is that RFM had sought to enrich itself at the expense of unitholders in structuring the guarantee. These claims were deliberately misleading and false. Firstly, the facility was structured as a wholly owned subsidiary of RFM to maintain RFF's REIT structure by quarantining operating risks and responsibilities. Secondly, the profit of this entity is limited to RFM's usual RFF management fee of 1.05% of the RFF guarantee.
As is highlighted in the next bullet point on this page, the variation to the existing arrangement will have no impact on drawn debt or gearing. RFM has sought the opinion of an independent expert who's concluded that the arrangement is both fair and reasonable to nonassociated unitholders. This independent report as well as documents for unitholders to consider and vote on this change will be posted on the 10th of March. RFM will hold a webinar for unitholders after this date with details to be announced by the ASX. RFM's expectation is that unitholders will only be too pleased to support the growth in the Australian beef industry exports by approving the increase to the guarantee. This expectation is based on unitholders' previous approval and the opinion of the independent expert. As a result, RFM has increased forecast FY '20 AFFO to $0.135 per unit.
We now move on to investment opportunities, 1 and 2, that is productivity improvements and higher and better use. The map on the left-hand side of this page is of the cattle property Comanche. Since acquiring Comanche, RFM has funded and RFM has overseen the development of 342 hectares of cultivation. There are plans to develop a further 147 hectares to irrigation. As highlighted by the picture of this farm at the start of this section of the presentation, both of these activities will greatly improve carrying capacity and mitigate seasonal variability.
The map on the right-hand side of this page show recently acquired sugarcane farms, which RFM will develop to macadamia orchards, a higher and better use. All developments will be managed by utilizing the RFM management that run the existing RFM -- RFF orchards. While the cost of these acquisitions and developments are not substantial, it will provide an opportunity to expand in a prosperous industry. Discussions with third-party lessees are also underway.
RFM is currently conducting due diligence on additional acquisitions of both of these types of investment opportunity and expect to be in a position to announce further details over the coming months.
Page 14 lists similar developments underway on 18 properties, seeking to improve productivity or realize higher and better use potential. These developments are occurring in cattle, macadamia assets. Examples of cattle and macadamia developments have been provided. And as we move to the fund update section of this presentation, this next page shows a cropping asset improved by RFM. On this property, Lynora Downs, RFM has developed additional water storage capacity of 4,250 mega liters. This picture was taken in the past few weeks and shows full water storages, which provide the lessee with the ability to plant up to 1,000 hectares of cotton.
The map included here provides details of the 38 properties owned by RFF, which are diversified across 5 agricultural sectors and 3 climatic zones. These elements of diversification is shown again on the next page in the form of pie charts. The bottom right-hand chart shows the mix of indexation mechanisms included in the lessee -- the leases in the portfolio. A further benefit of selling RFF's poultry assets is that it has increased the proportion of leases with fixed indexation and those which have market rent reviews. Market rent reviews are typically included in leases of assets, which are suitable for productivity development. That way, as improved productivity flows through to independent valuations and to the lessee, such as it has on the Natal aggregation, it can be monetized via a rent review.
In addition to an improvement in lease indexation mechanism, the disposal of poultry assets further improves RFF's profile of counterparts. As shown, 78% of lessees are corporate businesses and are listed on domestic and international exchanges, either directly or by their parent company. And just 6% of income is derived from smaller private farming operations and 16% of income is derived from lessees, which are either RFM funds or RFM directly. Both of these arrangements provided RFM -- provide RFM, as manager, valuable operating and development experience, which benefits RFF, exemplified by the higher and better use and productivity developments highlighted in the cattle, cotton and macadamia sectors today. Another benefit of this structure is that operational risks are [combined] to RFM as lessee, thus enabling RFF to maintain its REIT structure.
Page 19 considers issues relating to the environment, society and governance. The first picture is of an aboriginal fish trap on RFF's Tocabil property that has been identified by RFM and is in the process of being registered and protected. The second picture is from a projected -- a project sponsored by RFM in Cambodia. RFM and staff are donating $1 million over 3 years and providing expertise to assist a Cambodian community increase the yield from their farms. The rice crop pictured yielded more than double previous harvest and is a consequence of the precision farming skills and management expertise that RFM has been able to supply. This successful project is gaining great attention and the support from the direct community and now the wider area. This page also notes the important systems RFM has in place to ensure compliance with the environmental and governance considerations, which are included in RFM's policies, procedures and, importantly, our culture.
As we move to the conclusion of the presentation, I'll note that it is this same culture and structure I've just described which has resulted in the successful track record that is shown in this graph, that is, a business which has increased the number of assets, the value of those assets and, importantly, the income generated by those assets, which supports growing distributions. As already outlined, the aim of RFF's strategy is to support the increase of distributions of 4% per annum. Page 22 of the presentation confirms this strategy is being achieved.
In conclusion, the half year to 31 December 2019 delivered a positive set of results, which are delivering on strategy. Underscoring the strength of these results, RFM has announced today an increase in adjusted funds from operations, or free cash flow, of 11% per unit; surplus cash coverage of distributions demonstrated by a forecast 80% payout ratio by year-end; a healthy balance sheet with gearing below the target range of 30% to 35%; a diversified portfolio of lessees, which generate cash for RFF with a long weighted average expiry of 11.5 years; an increase to RFF's FY '20 forecast AFFO to $0.135 per unit; and the announcement of the forecast FY '21 distribution of $0.1128 per unit, delivering yet again a 4% uplift in distributions.
This concludes today's presentation. The appendices provide more information on the results, assets and leases, which you might find useful. I would now like to invite questions from participants.
Questions and Answers
David Anthony Bryant, Rural Funds Group - MD & Director of Rural Funds Management Limited 
The first question we have is considering the coronavirus, the impact on the fund and the agricultural sector more broadly. There's been no impact on the fund and nor should there be that those risks are borne by our lessees. There is no doubt that export of Australian commodities to China stopped -- all but stopped during the first quarter of this calendar year. They're speaking to our lessees who have export -- exports going to China. They have started to flow again but slowly. But there is little doubt that there has been an impact.
Despite that, we've seen with -- in cotton, for example, cotton is off probably only 5%, the cotton commodity price. Beef prices in Australia are up about 20%. That's driven by the drought. The beef exports to China are going to -- as trade resumes, are being balanced by the swine flu and, therefore, the protein gap that still exists in China. But there's little doubt that during that first 3 months -- or that past 3 months, people weren't going out, and beef is primarily a product that's consumed in restaurants and other places rather than at home. So if they're not going out, it wasn't being consumed. But those frozen stocks are now starting to move through the system. I think we can also expect the same for the other commodities. So there's little doubt that there's been an interruption in 4 commodities exported from Australia's agricultural sector.
As far as other comments on the coronavirus, I've really -- there's no point in me providing comments. I'd recommend -- the Economist Magazine is producing an excellent series of articles, and I'd recommend people seek those out because it's providing a really comprehensive view of all of the aspects of what's going on.
There's a question there, which is what happens now in relation to Bonitas. Well, they'll find out in due course.
Another question regarding the vineyard segment. We haven't added any vineyards in the last 15 years, which is absolutely accurate. We're really just, I suppose, biding our time. We have actually investigated new plantings. And I think, in time, there will be a requirement for additional plantings. If we can get the right counterparty for -- to plant new vineyards in ultra-premium areas, then we would pursue that. And we've got our sights on blocks of land that would be suitable for it, and we have access to water entitlements to enable it. But I wouldn't foresee that that's going to occur in the next 12 months.
The industry generally is probably suffering in the U.S. from an above-average crop. That's really just part and parcel of the cyclical nature of these industries where you'll have years of high production and then that will be caught up with years of low production. And through the long term, I think the prospects for Australia's wine industry is very sound.
There's a question there which is why do I think that the share price has not climbed back to the value prior to the first short seller report. I'm not an expert on financial market, so I really have nothing to offer on that. I'm sorry.
There's a question there whether we're considering further acquisitions. We certainly are because we have the balance sheet capacity to do so and have undertaken to deploy the cash realized from the poultry sales. We -- I really think that our next acquisitions will be in the cattle and macadamia sectors. We really are excited by the opportunities for higher and better use in the macadamia industry. And also, we continue to see lots of properties where the constrained access to capital of previous private owners have not enabled the development or the full utilization of the natural resource endowment that many of the properties have. And I suppose there's nothing we like more than getting out there and improving those properties, seeing the benefits flow through to the lessee and then to our unitholders as indexation and market review clauses lift the earnings for the fund.
Okay. And then there's a question there: could we explain how the increased JBS guarantee lifts earnings? JBS will pay a higher fee because there is a higher guarantee. They, in turn, will -- are happy to do so because they'll put more cattle through their feedlots and export more and meet the demand for Australian beef, which is now recognized worldwide as of the highest quality and, in fact, higher in quality than U.S. beef in many markets. So I think that it's a wonderful thing that we can be part of supporting that growth in the industry.
A question: on the back of the drought and bushfires, is -- are there any lessees in arrears? We have 1 lessee that is one we provided terms whereby their -- 1 quarter of the annual rent is in arrears. That will be caught up with interest. That was to provide accommodation to the lessee because they had recently acquired the property and had received no rainfall during that drought. They have now received ample rainfall. And I will add that, that lessee, that amount of concession represented less than 0.5% of the fund's AFFO. So it's a real testament to the diversity and strength of our counterparts and the quality of the assets that we have now passed through what was a very severe drought along the whole Eastern Seaboard and have only witnessed just -- only 0.5 of 1% in arrears. And that will be caught up, as I said, with interest. It's also a very good lessee who's doing a great job in improving that property for their benefit and for the benefit of RFF unitholders as a rent review flows through in due course.
We got several questions about what sort of acquisitions we're looking for and, for example, have we been looking at avocados, lamb and sheep farming and so forth. We look at all of these things. The mature avocado orchards are a bit pricey for my liking, but other people might have a different view of it, and good luck to them. The lamb and sheep industry is very attractive. It could integrate with some of the assets that we acquire where you have beef or cropping and you can have sheep in and around those assets. We've got sheep on -- one on the Tocabil property, which has an almond orchard leased to Olam. So we'll continue to consider that industry. Sheep meat prices are at an all-time high, and it's a great industry to be in, and wish we had bought up farms in it 10 years ago, I suppose. But we've done pretty well out of the other assets and cattle sector that we've been in.
Question regarding the outlook for the water market and the impact on water rights held by RFF. I would expect that water values will probably plateau from here because they're at levels where -- if you've got owners of water entitlements that are just simply renting them out, such as some of the foreign investors that have bought a lot of water entitlements without farms, the rents that they can get on them -- they are paying such high watering prices for those entitlements that the rent that they must need to get on them is diminishing as a return on equity. So I think that the propensity of foreign pension funds and other traders of water, the propensity to continue to beat up entitlements, I think, is limited. But that could vary basin by basin. The main is the Murray-Darling Basin, of course, and that's where I'm addressing my comments. The outlook for RFF's water entitlements remains good. Most of those are committed and encumbered by leases, but we have a very large parcel of high-security entitlements that we sell into the open market from year-to-year. And that's been a very, very lucrative investment.
There's a question that -- do we have any lessees that are looking for more properties or longer leases with us. And the answer to that is unequivocally yes. The arrangement works very well for our lessees, and they are attracted to the model. And it allows them to secure supply for their markets, in particular, and their processing capacity, which is important to be fully utilized. So we continue to work with lessees to discover and then acquire additional properties. And we remain very optimistic that we'll deploy further capital doing just as I've described.
And we have a question regarding our weighted average rent reviews. If we combined our market reviews and all the other mechanisms, would -- the question is would the combined average of that equal around 2.5% per annum. It certainly would. You need to also keep in mind that RFF has the benefit of a low payout ratio. So we have roughly 20% of the cash -- the free cash we're generating each year is plowed back into new rent-getting or money-getting investments and that's what's assisting us to grow that AFFO or their funds from operations at a healthy clip, and that's what's supporting the distribution growth rate that we continue to deliver.
All right. I think that concludes the questions and -- oh, actually, there are a couple more coming in. Okay. There's a -- we have one last question, which is what exactly is RFF guaranteeing for JBS. So it's a limited guarantee, and I'd urge the questioner, [Larry], if you want to look at the documents that are loaded up on the ASX today, you'll be able to read your way through that. But it's a limited guarantee for a debt facility provided by Rabobank and ANZ Bank, which funds the acquisition of cattle and feed that are housed in the feedlots owned by RFF and rented to JBS. So it's a facility that guarantees -- it's a guarantee for a debt facility to fund the livestock within our feedlots.
And then one last question which is the incremental yield on CapEx. All of our CapEx attracts rent. I don't think there's any material instance where we're outlaying CapEx that doesn't. And as to average across the portfolio, any CapEx, on average, generates 7% return on capital deployed.
And with that, I think I'll wind up today's presentation. It's a very pleasing set of numbers, and we're very happy to have you attend and look forward to delivering a similar result in the coming months. Thank you.